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Wither Flation?

By: Frank Armstrong

By: Frank Armstrong, III, CFP®, AIFA®

Numerous reports estimate that the total cost for the announced US Government programs to cure the financial crisis and jump start the economy adds up to a cool $7 Trillion!

This is a really big number, and it sticks in people’s minds. A lot of that will never actually be spent because it includes guarantees that may never be triggered. However, whatever the real amount is it’s still a large number. No, it’s an astounding number; a number so large that few of us can get our heads around it.

We all know that there is a relationship between money supply and price levels. So, the $7 Trillion dollar number immediately brings to mind uncontrollable inflation, and the prospect of wheelbarrows full of hundred dollar bills to buy a loaf of bread.

Some politicians, some media, and some financial “experts” are having a field day with the hyper inflation scare.

But, hold on, it’s not quite that simple.

The real economy is in a very strong downward slope. While there are glimmers that the pace of decline is moderating, economic growth is still some time away. Economic contraction is not generally associated with strong inflation.

On April 15, 2009, the government announced that the twelve month Consumer Price Index (CPI) fell for the first time since August 1955. Clearly, based on the recent CPI numbers, inflation is not an immediate threat.

Much of the global economy is faced with serious deflationary pressure: energy and commodities, labor and real estate prices are in a virtual free fall. Deflation is a clear and immediate danger that probably scares central bankers more than the prospect of inflation later. They fear that Capitalism won’t work well in times of broad price declines because no one will buy anything today if they believe that tomorrow’s prices will be lower. In reality, the government targets an inflation rate of 2.5 to 3.0 percent to keep commerce moving smoothly.

Monetary Policy

When faced with recession and falling prices, one possible remedy is for the Federal Reserve to increase the money supply. One simple way for them to do that is just to buy bonds. Because they are the nation’s central bank, they can just magically create the money. They exchange dollars which they make for bonds that already exist. The end result is that there is an infusion of dollars into the economy.

Another trick the Fed can use is to lower interest rates. Traditionally they changed the discount rate to influence short term rates. But, after short term rates got to close to zero, they went after long term rates by buying Treasury Bonds aggressively.

The Fed hopes that with all this new money floating around and low interest rates, banks will lend and people will buy. Further, they hope that more money will jump start economic activity and stabilize prices. None of this is guaranteed to happen. If people are really scared, they won’t buy or borrow or lend anyway. But, that’s another story.

So, right now, the Fed has little reason to be concerned about inflation and every reason to want to increase economic activity. They are flooding the market with money and making no bones about it.

But, what about later when the recovery is under way and inflation becomes a concern? They just reverse the process, sell bonds to soak up the dollars and increase interest rates. The trick is in the timing. But, that’s what the Fed is supposed to do.

Fiscal Policy

Now that you understand all there is to know about monetary policy, let’s take a quick look at the other tool the government has to regulate the economy. Fiscal policy at its simplest is spending more or less than taxes generate. If the government wants to increase economic activity, they just embark on a little deficit spending. Governments being what they are, they are not so good at fiscal restraint, and we haven’t seen too many budget surpluses lately. But, unlike monetary policy which may not produce the desired result in buying, lending and borrowing, when the US Government buys something they will directly make things happen. Fiscal stimulus is the big stick of economic policy, and it’s fair to say that it’s cranked up to high, too. Just look at the deficits we are projecting.

With both monetary policy and fiscal policy running at full tilt eventually there will be some inflationary pressure, and we can only hope that the government will put the brakes on at a timely moment.

The government will never admit this, but a little inflation now would go a long way toward solving some of their problems, especially in the housing markets. If housing prices were to rise to the point where few owners were underwater on their loans all that junk financing would turn golden. Banks and other financial institutions that owned all that junk would have solid balance sheets, a market would develop for the toxic debt and the financial crisis would abate. It’s hard to believe that hasn’t crossed their minds.

Economic policy is a constant balancing act. Neither deflation nor inflation is a necessary outcome to today’s problems. Hyperinflation is a possibility if the government drops the ball. But, it’s certainly not inevitable.

What should investors do?

While it generates a lot of media chatter and cocktail party conversation, no one knows whether we will have inflation, deflation or stagnant prices. If we really knew, we could buy a few options and sail off into the sunset. In an efficient market the consensus opinion is constantly factored into security prices. Perhaps a billion of your closest friends are looking at the economic problem and placing their bets. In the process,s prices are adjusted in real time. So, investors shouldn’t be speculating on either. But, they should position their portfolios to survive. A sophisticated asset allocation policy will go a long way toward protecting the value of their investments in many likely scenarios.

Should we have some inflation, past experience indicates that stocks are a very good hedge. They have always produced superior long term real returns. Very shortly businesses learn how to pass on increased prices to their customers and protect their real profits. Real Estate and Commodities are also very good inflation hedges. Short term bonds will quickly adjust to inflation expectations and protect capital. Even the US Government can’t long sell Treasury Bills at far below the expected inflation rate.

The biggest losers in inflation are long term bond holders. Of course, they would be big winners in the event of a deflation. But, unless the investor is convinced that deflation is a virtual certainty, he would want to avoid long term bonds. The risk reward tradeoff is simply not favorable.

The impact of inflation on the dollar depends to a large extent on the economic performance of other countries. After all, if another country has a higher rate of inflation than we do, the value of the dollar may very well go up. Europe probably has a larger crisis on their hands than does the US. But, other economies may be better positioned. All in all, it’s not a sure thing that the dollar will tumble as a result of our problems. But, a portfolio with a high proportion of foreign equities provides a natural dollar hedge.

Conclusion

It’s never a good idea to speculate based on idle chatter. The very best course of action is to construct an investment plan that meets your specific financial situation, objectives and risk tolerance and stay the course.